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True, yields are pretty paltry these days, with the 10-year Treasury at 1.8%. But that hasn't stopped Steve Tananbaum, a seasoned hedge-fund manager who specializes in below-investment-grade credits, from finding good opportunities.

Tananbaum, the managing partner and chief investment officer of GoldenTree Asset Management, is particularly high on bank loans. However, he is steering away from the debt securities of companies that he thinks have too much leverage, such as Clear Channel Communications. At the same time, he considers the current environment to be pretty benign for many junk bonds, whose yields exceed 10-year Treasuries by more than five percentage points—a spread he thinks gives investors adequate protection. And—compared with other parts of the world like China and Europe—the U.S., in Tananbaum's opinion, is producing more reason for optimism. His firm expects gross domestic product to grow 2% next year.

"We are still in the beginning of the rate cycle, because it hasn't responded well to stimulus from the Fed." -- Steve Tananbaum
Evan Kafka for Barron's

Tananbaum first made his mark in junk-bond investing at New York money manager MacKay Shields in the early 1990s, while still in his 20s. Eager to run his own shop, Tananbaum in 2000 co-founded New York-based GoldenTree, which has $16.3 billion under management, spread across bonds, bank loans, distressed investments, private equity and structured products, such as collateralized loan obligations.

From its inception in March 2000 through Aug. 31 this year, the GoldenTree Hedge Fund Composite, a proxy for the firm's performance, has had an annual return of 10.5%, net of fees. That compares with a return of nearly 6% for the Dow Jones Credit Suisse Hedge Fund Index over the same period.

Barron's caught up with Tananbaum recently at his midtown office.

Barron's:Very early in your career, you spent time analyzing stocks. What are your thoughts about value investing and growth investing, and do they have any similarities to credit investing?

Tananbaum: In value investing, you are trying to buy a dollar for 50 cents. Similarly, in credit investing you want to create a margin of safety—for instance, buying a dollar of value for 50 cents with a contract in the form of covenants. And you are willing to take less return potentially if your contract is very good. And like the equity market, debt investing can be very fickle, in terms of what the prospects of a company are or how good your contract is. So if you can buy when the prospects are bad and people doubt the enforceability of your contract, that is a good thing.

A growth investor is thinking of the upside and what the discount rate is for that upside. Not that the downside isn't a criterion, but for some of the best growth opportunities, the issue isn't whether it is a good situation. With
Google
[ticker: GOOG], it isn't an issue of whether it is a terrific franchise; it is. It is just, "What's the right discount rate, and where will it grow?" That certainly comes into debt analysis. But because your upside is often limited by your contract when you invest in debt, you are much more concerned about the downside than you are about the upside of the business.

It's been an era of yield compression, with the 10-year Treasury around 1.8%, having backed up a little recently. What are your big-picture thoughts on the credit environment?

There is yield, there is spread, and there is where we are in the cycle. The absolute yields look very low by historical standards. We are still in the beginning part of the interest-rate cycle, because it hasn't responded well to stimulus from the Fed. So interest rates, as we saw them do in the early 1990s, are going to move before the targets do, if the economy is healing itself.

Before which targets?

The Fed's targets. The Fed just announced that it plans to keep rates low into 2015. But the markets will anticipate [a change earlier] if the U.S. economy is healing. As a result, the 10-year and shorter yields will rise. As for spreads, [the difference between the yields on "risk-free" Treasury bonds and other debt securities], they are still only about average. And when you look at what the alternative is—namely cash—it is still relatively benign for below-investment-grade debt. So the spread on that debt is about 530 basis points, or 5.3 percentage points, over the risk-free rate. When you have lower expected default rates with around 530 basis points of spread, that's been a good time to invest in the below-investment-grade credits, which is what we focus on at our firm.

So, there is somewhat of a tug-of-war between the base interest rate, which looks vulnerable to me, and the spread, which looks fair because default rates are low. Overall, the underwriting standards have remained strong and consistent with what we usually see earlier in a cycle—not later.

Just to be clear, high-yield spreads are about 5.3 percentage points?

Right. That's broadly speaking. And forward default rates are expected to be about 2% and the loss rate is about 75%. So if you have a default, on average you recover 25 cents on the dollar. All of this means that if spreads are 530 basis points and your loss rate is 75% and defaults are 2% to 3%, depending upon what you are looking at, you are talking about another 2% of loss that's expected for at least the next year or two. So, that leaves more than three percentage points excess spread, versus a 10-year Treasury that is yielding 1.80%. That's a very big pickup.

And that's bonds. On bank loans, or leveraged loans, you are getting, say, five percentage points of spread over Libor [the London interbank offered rate, a key benchmark for loans]. Call the default rate 2%, but your recoveries are a little better than they are in high yield. And because most bank loans have floating-rate structures, you actually do not take any interest-rate risk. So we find that bank debt is probably cheaper on a spread basis.

Is the bank debt you own used for leveraged deals?

There's a lot more money being used for companies to make acquisitions and for other types of growth than for leveraged buyouts.

You aren't as bullish on corporate debt? Why?

With corporates, you are probably more tied to interest-rate projections, because that's a bigger component of the price movement. I'm talking about nonfloating corporate debt. You have to understand the bets you are taking and, in the case of corporates, you have more of an interest-rate component to your investment than you do with high-yield bonds.

So overall, high-yield debt is attractive?

I would put high-yield at neutral. You're probably vulnerable with interest rates, but you have some cushion with the spread, so they probably cancel each other out. Bank loans are more attractive because you are actually being given a pretty wide spread, based on historical measures. We also like residential mortgages. But the part of the market I'm most excited about is structured products, specifically CLOs [collateralized loan obligations].

Why CLOs?

We view their structure as the best value because there are very strong fundamentals. I don't want to downplay that we find residential mortgages attractive. But in the underwriting of CLOs, the loan-default rate is assumed to be around 4%-5%, but is going to be around 2%-3%. So, when we are in a low-default environment, those structured products get healthier. So you can still get some of the more junior parts—the BBB-rated credits, for example—of a company's capital structure at 70 cents on the dollar. Those credits are investment-grade, albeit toward the lower end of investment-grade.

What sectors of the credit markets are you avoiding?

Some of the CCC-rated parts of the market, where a company has to grow into its capital structure, although these credits are giving you the highest yield. A company needs to have strong growth to justify those yields.

CCC is below investment-grade. I'm talking about CCC names that are primarily at the bottom part of capital structures. We think those securities are vulnerable.

What do you mean by "grow into them"?

The company needs to de-lever and pay down debt. So that's where I don't think it is a smart risk-return ratio. I'd say the theme would be to avoid where you need a lot of growth to justify the current levels of leverage. Clear Channel Communications is an example of a very leveraged capital structure that hasn't shown the growth to justify the existing leverage. And, therefore, the credit is dependent on a higher valuation. It could happen, but it doesn't offer us the degree of safety we're used to.

Whoever is at the bottom part of the capital structure gets paid last, if at all, in a liquidation, correct?

Right. So some of those big leveraged buyouts are vulnerable, as are some of the coal names from the credit side.
Arch Coal
[ACI] doesn't look like it generates a lot of free cash flow in this environment, so its debt looks too expensive to us. The company is in a business that is very cyclical and has a lot of volatility.

Overall, high-yield debt has had a good run. When does it come under pressure?

Part of that run also has been a function of what's happened to 7- and 10-year Treasuries, which have had a very nice run as well. With yields as low as they are, high-yield is a more attractive option. As I mentioned, I do think there's going to be a tug-of-war between spread and base interest rates. And if you believe that the economy is doing better, the base rate will go higher and bond prices will go lower. Spreads usually tighten in a rising rate environment.

What are your thoughts about Europe?

I'm concerned about how Europe's economy is more volatile than the rest of the world's. And there's the question of whether it will integrate. Will there be not only a monetary union, but a fiscal union as well? Is it possible politically? Another concern is the U.S. presidential election. I don't want to get into politics, but there are still some uncertainties, whether it's the fiscal cliff, entitlements, taxes, etc. Having said that, the U.S. probably has more upside to GDP estimates than downside to estimates, particularly when we get through the budget and fiscal-cliff issues. China is somewhat of a black box, and it seems like the shadow consensus on China is more like 5% GDP growth this year, not 7%. So with the two overhangs—China and Europe—the U.S. in general has been benign.

So you don't expect a recession in the U.S. next year?

I believe the fiscal cliff will be solved and smoothed out, and our base case is growth around 2% next year. On the other hand, it is not as if we will have GDP growth of 4%. We are at 1.5% to 2%. If we retrace to 0% or 1% growth, that would be disappointing to the markets. But in the broad scheme of things, that would not be out of context. We are not that far away from a recession and, certainly, a recession in earnings. When you get below 1.5% GDP growth, earnings tend to trail down.

Let's hear about some of your holdings.

One is Numericable, the largest French cable company. It's not publicly traded, but the debt is pretty active. The notes I'm talking about mature in 2019, with a coupon of 12.375%, and they are yielding about 10.5%. They are trading at 110, above par. The company has a very similar profile to Cablevision's here in the U.S., but we think Numericable has better growth and better free cash flow as a percentage of total debt. The comparable Cablevision bonds yield around 6%. So it is 400 basis points, or four percentage points, cheaper for a company that has similar stats and better free cash flow. This year, Numericable will do about $600 million of Ebitda [earnings before interest, taxes, depreciation, and amortization].

What's your biggest concern about this company?

Europe. We bought these bonds at 95 or 96 cents on the dollar when they were issued earlier this year, and they have done well. But they still look very reasonable, relative to the U.S. cable companies. We figure the yield could slip to 8%, which would get the price to $117.50 from $110. If the yield fell to 9%, the price would be $113.

What about some other holdings?

Caesars EntertainmentCZR 0.6172839506172839%Caesars Entertainment Corp.U.S.: NasdaqUSD8.15
0.050.6172839506172839%
/Date(1481301552041-0600)/
Volume (Delayed 15m)
:
163316
P/E Ratio
N/AMarket Cap
1190400335.29777
Dividend Yield
N/ARev. per Employee
136455More quote details and news »CZRinYour ValueYour ChangeShort position
[CZR] has a revolving credit facility of about $900 million that comes due in 2014. It trades at 95 cents on the dollar. We expect that to be addressed by a refinancing in the next six months, so we see five points of upside there.

Elsewhere, some of Argentina's sovereign debt trades above 12%. Even though I'm not in love with the government's policies, it certainly seems to have very good statistics, relative to other countries that have very similar debt-to-GDP ratios and are running deficits around the same size as Argentina's—and yet those credits yield a lot less. Portugal's sovereign debt is yielding about 8%. Argentina's debt certainly had a nice runup, from 52 cents on the dollar when we bought it this spring to 67 recently. But it still looks reasonable.

Are you worried about Argentina defaulting on its debt, as it did in 2002?

We feel we are being compensated for that risk. On a relative basis, what their debt is yielding is hard to find in the sovereign debt of major countries with anywhere near Argentina's stats. This isn't a large position of ours, but it has worked very well recently.

What about holdings closer to home?

Hilton Worldwide. When
Blackstone GroupBX 0.9869171418986917%Blackstone Group L.P.U.S.: NYSEUSD30.1042
0.29420.9869171418986917%
/Date(1481301567158-0600)/
Volume (Delayed 15m)
:
2370874
P/E Ratio
25.695216907675196Market Cap
18812299452.9371
Dividend Yield
5.461205461205461% Rev. per Employee
2194980More quote details and news »BXinYour ValueYour ChangeShort position
[BX] took Hilton private in 2007, there was a mortgage note and several mezzanine tranches. As an investor, you are secured by all of the assets of Hilton. We own a significant piece of the mezzanine tranche D. The debt matures in late 2015 and has second-lien status. It trades around 94 cents on the dollar and is yielding 7.5% to maturity. When we bought it earlier in the year, it was trading below 90 cents. The catalyst is that we expect Hilton to do an IPO within the next year, probably in the first half of 2013. In that scenario, we would expect them at the time of the IPO to refinance all of the mezzanine debt at par.

What's your view of the hotel industry?

Generally speaking, hotel fundamentals are very strong, particularly in the U.S. On average, RevPAR [revenue per available room] is trending up in this country. It's increased about 7%, year over year. Broadly, that shows a very positive operating environment. This is driven by what's happened through the recession, with the amount of hotel development much below average.